A new year brings new year resolutions. Here at Trellis Legal, our resolution is to reduce our use of single use plastics and to visit more farm stands! Whatever your resolution is (or isn’t), if you have an LLC or partnership without an operating agreement, you should strongly consider formalizing one as a part of your new year’s resolution.
What is an Operating Agreement
An operating agreement is a legally binding document which creates and codifies protocols, rights, and responsibilities of your LLC and its members. For instance, an operating agreement typically lays out the duties of LLC members, the amount of shares each member owns, member’s voting rights, steps for dissolution of the LLC, and any other important business information.
Advantages to having an Operating Agreement
Even though most states do not require operating agreements, it is still advantageous to formalize your business agreement. In Pennsylvania, operating agreements are not required for LLCs. Nevertheless it is always a good idea to have one of these agreements, because it creates a procedure on how to deal with an array of situations. Many major conflicts and misunderstandings can be avoided with a thorough agreement.
Without an operating agreement, the default rules of the state in which your LLC is based will govern how your LLC may proceed. Sometimes these rules do not create the most efficient business model. For example, if your LLC does not have an operating agreement, but has two members, the default rules of PA will result in 50/50 voting power for both members. This can result in LLCs being gridlocked and unable to make decisions when the partners cannot agree, which can be especially painful when the decisions are over trivial matters. Instead, an operating agreement can layout how voting power relates to investment, or other components as to why one member might have greater voting power allowing for more ease in decision making. The agreement can also allow for one member to make decisions on daily matters without consulting the other partner optimizing efficiency.
Also, the PA default rules are not one size fits all, and are minimal. This means they are unlikely to address some of the specific situations which may arise leaving your business on uneasy legal footing. Let’s say your LLC would like to remove a member, but never created an operating agreement, in Pennsylvania only a few situations would allow for the removal of that LLC member. So, without an agreement, you may be left to generic LLC laws which may not contain the best solution for your company or may require expensive legal work and court approval. Therefore, it is best to consider these components while the business relationship is strong and formalize solutions through an operating agreement.
Additionally, an operating agreement allows a business owner to have more control and understanding of the LLC. An operating agreement can detail how profits will be split, or conversely how debts and obligations will be allocated. If this is not detailed, the default in Pennsylvania will be for profits to be split evenly among the members, and for any debts to be borne solely by the company. While some default rules might sound perfect for your company, it is best to put these terms in an operating agreement so that it is understood by other members, and so that if you want to change or modify them it will be easier to do so.
Even if you are a one person LLC, it is still important to have an operating agreement to help ensure your liability remains limited. Courts tend to favor single-member-LLCs who have created an operating agreement. This is because the agreement formalizes how the LLC is separate from the individual member. Therefore, an operating agreement can make it harder to “pierce the corporate veil,” which means when an opposing party can get through the limited liability protection to the LLC owner’s personal assets.
Not all Operating Agreements are created equal
Even if you already have an operating agreement, it might be time to fine tune it or make some changes through amending the agreement. For instance, if you created your operating agreement via an online form it still may need some tailoring based on how your unique business has been operating. Also, if your business has recently added or removed a member, the business has gained more capital and assets, or has made any other major changes, it is probably time to amend your operating agreement. Any changes must be approved according to the voting procedure detailed in your current operating agreement (another important aspect to consider!). Either way, it might at least be time to dust off the old operating agreement and give it a once over to make sure it still reflects how your LLC is operated.
An operating agreement encompasses almost all situations that an LLC can be confronted with, and the beauty of the agreement is that it will detail how to handle everything from a member meeting, to a member’s death. Essentially, if you have an LLC with no operating agreement, it is time to look into creating one. Of course, we at Trellis Legal would be happy to create an operating agreement for you, or look over an old one to see if it needs updating. However, the most important thing is is that you create an operating agreement sooner rather than later, because you never know when it might be very important to have.
This blog is meant for informational purposes only and does not constitute specific legal advice or create an attorney-client relationship. Readers should discuss their specific situation with an attorney and accountant.